We may have seen the worst in the run up in mortgage rates

Pasadena Mortgage rates for July 22, 2008. Loan amounts up to $417,000:

3/1 ARM 5.750%

5/1 ARM 5.875%

7/1 ARM 6.250%

10/1 ARM 6.500%

30 Yr Fixed 6.500%

All rates offered to the borrower with 1 point cost. Rate quotes assume a purchase transaction with a 20% down payment, 720 credit score, and full income qualification. Rates are subject to fluctuation. Custom rate quotes and rate lock advice are available by calling (858)-777-9751.


Next 7 days: Slightly Lower

Next 30 days: Lower

Next 3 months: Neutral

What a difference a week makes, huh? Last Tuesday, I signaled that a short-term increase in rates was likely when I changed the 7-day outlook to "slightly higher" from neutral. I felt that the rally in mortgage bonds was overdone and that traders would sell off a bit; I had no idea it would be this drastic.

If you click the link, you'll see that I offered a 30-year fixed at 6.0%. last Tuesday- today, the 30-year fixed rate loan is a full .5% higher. In fact, almost every loan program is .5% higher than it was last week. The problem? Wall Street thinks the worst is over for banks and that inflation is going to be the #1 target for the Fed in the next few months. ' Treasury Secretary Hank Paulson is certainly telling the markets that the banking crisis should be averted by Christmas.

So will the Fed raise interest rates in 2008? I'm not so certain that they will. The housing decline has been the worst since The Great Depression. Fed Chairman, Ben Bernanke, is an expert on monetary policy in the Depression. He subscribes to the Milton Friedman theory that monetary policy must accommodate a healthy banking system. His 2004 speech signaled two things two us:

(1)- Bernanke believes that tightening during a slowdown could cause further economic declines:

According to Friedman and Schwartz, the Fed's tight-money policies led to the onset of a recession in August 1929, according to the official dating by the National Bureau of Economic Research. The slowdown in economic activity, together with high interest rates, was in all likelihood the most important source of the stock market crash that followed in October. In other words, the market crash, rather than being the cause of the Depression, as popular legend has it, was in fact largely the result of an economic slowdown and the inappropriate monetary policies that preceded it. Of course, the stock market crash only worsened the economic situation, hurting consumer and business confidence and contributing to a still deeper downturn in 1930.

(2) Bernanke believes that a contracting banking sector withdraws a HUGE amount of money out of the economy:

The banking crisis had highly detrimental effects on the broader economy. Friedman and Schwartz emphasized the effects of bank failures on the money supply. Because bank deposits are a form of money, the closing of many banks greatly exacerbated the decline in the money supply. Moreover, afraid to leave their funds in banks, people hoarded cash, for example by burying their savings in coffee cans in the back yard. Hoarding effectively removed money from circulation, adding further to the deflationary pressures. Moreover, as I emphasized in early research of my own (Bernanke, 1983), the virtual shutting down of the U.S. banking system also deprived the economy of an important source of credit and other services normally provided by banks

His conclusion is foreshadowing:

Some important lessons emerge from the story. One lesson is that ideas are critical. The gold standard orthodoxy, the adherence of some Federal Reserve policymakers to the liquidationist thesis, and the incorrect view that low nominal interest rates necessarily signaled monetary ease, all led policymakers astray, with disastrous consequences. We should not underestimate the need for careful research and analysis in guiding policy. Another lesson is that central banks and other governmental agencies have an important responsibility to maintain financial stability. The banking crises of the 1930s, both in the United States and abroad, were a significant source of output declines, both through their effects on money supplies and on credit supplies. Finally, perhaps the most important lesson of all is that price stability should be a key objective of monetary policy. By allowing persistent declines in the money supply and in the price level, the Federal Reserve of the late 1920s and 1930s greatly destabilized the U.S. economy and, through the workings of the gold standard, the economies of many other nations as well.

I don't see the Fed aggressively raising interest rates to prop up the dollar. I think reduced demand will bring oil prices below the $100/barrel mark which will strengthen the dollar. The Fed's focus should have been (in the 1930s) and will be (this decade) to promote a healthy banking system. While the banks are reporting lower losses, they still aren't healthy. The recent good news from the banking sector needs to be sustainable. Look for the Fed to restrain itself from raising rates until 2009.

Are higher mortgage rates on the horizon? Sure, in 2009. The run up in mortgage rates I predicted, two weeks ago, has already happened. I don't think mortgage rates go much higher in 2008.